Oakmark Equity and Income Fund: First Quarter 2011

March 31, 2011

Quarter Review
We are happy to report a return to the Equity and Income Fund in the March quarter almost identical to that which we reported last year at this time. Similar to one year ago, the Fund’s 5% return slightly bested the 4% number that Lipper Analytics reported for its Balanced Fund Index. Once again, the Fund’s equities provided the bulk of the return, gaining nearly 7% in the period. Fixed-income investments recorded positive but minimal returns. For the first six months of the Fund’s fiscal year, the comparative numbers are 12% for the Fund and 10% for the Lipper Balanced Fund Index. Always of greatest importance is the comparison for the annualized rates of return since the Fund’s inception in 1995: 11% for the Fund versus 7% for the Lipper Balanced Fund Index.

It is somewhat curious that investment outcomes have been so similar for the first quarters of the past two years. The problems that we highlighted in our letter to shareholders one year ago still persist, in particular the financial distress in countries on the European periphery ( Portugal, Ireland, Greece and Spain). And, of course, all readers will be well aware of the March quarter’s world-changing events. Despite the world’s tragedies and problems, many businesses continue to add value, and increasing stock prices reflect this reality.

The recent quarter’s leading contributors to the Fund’s return were Cenovus Energy, Rockwell Automation, Concho Resources, United Health and ITT. While this is a more eclectic winner’s list than often emerges, the one commonality is that two of the top three contributors are oil/gas exploration and development concerns. This probably does not surprise anyone who has purchased gasoline recently. As we have often written, when we buy shares of a commodity producer, we attempt to do so at a share price that gives us free optionality. What this means is that we wish to own the company’s shares at a valuation that would be attractive if the price of the commodity it produces never changed from the moment of our purchase. The markets occasionally afford us such opportunities, and they often prove to be rewarding for our shareholders (examples of this include the Fund’s previous history with Burlington Resources and XTO Energy).

Cenovus is one of the leading participants in what is probably the largest petrocarbon resource deposit located in a friendly, stable country. Extracting oil from Alberta, Canada’s oil sands is expensive, so Cenovus’ shares generally benefit more from rising oil prices than most other energy producers. In contrast, Concho Resources concentrates on exploiting old fields in the continental U.S. Techniques used decades ago in oil/gas exploration could only remove a modest percentage of the underground resource. Today’s techniques allow for additional oil/gas recovery with considerably lessened dry-hole risk.

Leaving energy, Rockwell Automation, which manufactures devices such as variable-speed motor controls and programmable logic controllers, and ITT, a diversified manufacturer of products for the water and defense industries, both appear to have benefited from the renaissance in U.S. industrial production. Finally, United Health’s shares have risen as investors appear to be reassessing last year’s health-care legislation. We always state that we will consider investing in any legal industry as long as the valuation opportunity is compelling. Heretofore we had avoided the managed-care industry, but share-price declines in the sector and uncertainty from 2010’s health-care bill offered an attractive entry point for purchasing United Health shares.

The quarter’s largest detractors were Cisco Systems, Microsoft, Nestle, Boston Scientific and Scripps Network Interactive. We clearly have covered ourselves with something other than glory with our investments in large-capitalization technology companies. Cisco continues to suffer profit-margin erosion because of price pressure from newly invigorated competitors. Microsoft’s problems appear to be more strategic, and we exited the stock. The actual price declines for Nestle, Boston Scientific and Scripps were modest. The earthquakes in New Zealand and Japan have increased volatility in the shares of PartnerRe, a Bermuda-based reinsurance company. While the company will likely have to make significant payouts to its clients, the long-term impact on business value is less clear.

We kept the Fund’s equity allocation fairly constant in the quarter, but we continued to reduce the fixed-income allocation. The biggest change was a reduction in inflation-indexed securities (TIPS), which resulted when we did not replace a significant January maturity. The fixed-income duration remained flat at just over two years, meaning that this portion of the portfolio should have little sensitivity to interest-rate movement. We continue to believe that fixed-income investments are riskier than normal. Some readers may be familiar with Pimco’s Bill Gross and his critique of U.S. Treasury issues. We agree with Gross that unless entitlement spending patterns change substantially, the long-term outlook for government debt is unpleasant. Accordingly, we have oriented the Fund to an above-normal equity allocation and a below-normal fixed-income commitment.

Transaction Activity
Although we kept the equity allocation fairly constant during the quarter, we were quite active overall. We eliminated eight holdings, initiated two new positions and added to holdings that began the quarter with small position sizes.

Beginning with the sales, we have already discussed Microsoft, and Del Monte was bought out during the quarter. Diebold, Kirby, Rockwell Collins and Weight Watchers International either exceeded, met or approached our sell targets. We sold Unilever ( Great Britain shares) to reduce the Fund’s sensitivity to commodity prices. We sold Covidien to reduce our large weighting in health care. These holdings were all profitable for the Fund. Weight Watchers was a particularly outstanding holding, more than doubling in price in only one year’s time.

Our two new purchases were Pepsico and Range Resources. Pepsico is probably well-known to most shareholders, although the fact that the company is more of a food business (Frito-Lay) than a beverage business is often overlooked. Sluggish beverage growth in North America has helped to constrain the share price for the past year. Rising commodity prices have also reduced investor enthusiasm for the company. We believe that the share price more than discounts the headwinds facing Pepsico. We also like what we view as management’s shareholder-friendly orientation. Range Resources is an exploration and production company focused on natural gas, mostly in Appalachia and the Southwestern U.S. In our opinion, Range’s operating and finding costs are well below average, and the company shows rapid growth in production as well as proven reserves. We believe that at our purchase price, the stock traded at a substantial discount to the company’s asset value net of debt.

Risk On/Risk Off?
The Equity and Income Fund’s managers have both worked in the investment industry for many decades, so we both should be at the point in our careers where dubious financial-industry innovations no longer surprise us. Such an assumption, however, would be incorrect.

For the past few quarters we have repeatedly read that the daily outcomes in the securities markets are the result of the “Risk On/Risk Off” trade, wherein investors (sic?) react to the most recent news by buying equities/selling bonds (Risk On) or the reverse (Risk Off). As value investors we think this is pure nonsense. A single day’s events and data rarely affect the ability of a business to generate free-cash flow over the long term, and it is that sustained free-cash flow that we deem most important for investments. That said, we believe it is advantageous for us to have these Risk On/Risk Off traders in the market. They treat equities like commodities, using stocks to express a short-term belief about the market. It appears that their security selections have no foundation in fundamental business value. They are more than happy to sell when stocks are cheap or buy when they are expensive, as long as they can express their near-term market opinion. It is this sort of market action that makes it possible for value investors like us to prosper. If stock prices perfectly predicted the value of every business, value investors would be unemployed, so let’s hear it for the Risk On/Risk Off trade!

The recent quarter has certainly demonstrated just how dangerous the world can be, and shareholders have expressed interest in the portfolio effects from these events. Turning first to the Middle East and North Africa, our work suggests that the portfolio has had little direct exposure to the turmoil there. One possible exception is our stake in Apache, the diversified energy company that has significant investments in western Egypt. However, this area has not seen any disruption to date. The widespread efforts to effect government change have also caused oil prices to increase. While a negative for economic activity in total, rising oil prices have helped the Fund’s six energy-industry investments.

In contrast, the impact from Japan’s great earthquake will be felt across more companies and industries. The first Fund holding to disclose a problem was Texas Instruments, which has several Japanese factories. The company estimates that it could take approximately six months for its operations to return to normal there. We have already mentioned PartnerRe, the reinsurance company, in the opening section. TE Connectivity, the new name for Tyco Electronics, expects some setbacks in its sales pattern, especially in relation to the automotive industry. No doubt other companies will soon make similar announcements. We do not expect the cumulative economic effects from these events to significantly change our understanding of these companies’ intrinsic values. We do send our best wishes and hopes for all who have been or remain in harm’s way and look forward to more peaceful times.

We thank our shareholders for entrusting us with their assets. As always, we invite your questions and comments.

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